Mixing and Matching Electricity Sector Policies

A number of concerns have emerged over the last decade about climate change, energy security, and energy efficiency, inspiring an equally long list of proposed policy fixes. The majority of these options, including renewables subsidies, performance standards, and emissions pricing schemes, apply directly to the power sector. Lawmakers can also choose to implement multiple policies in tandem, as the European Union did in its 20/20/20 by 2020 targets—a 20 percent reduction in emissions, a 20 percent share of renewables in total energy consumption, and a 20 percent improvement in energy efficiency. Similarly, California, in adopting an emissions cap-and-trade system, is retaining renewable energy mandates and subsidies, as well as energy conservation policies. Despite the growing interest in using this mix-and-match approach, little research has been done to explore how cost-effectiveness and technological innovation are affected by interactions between coexisting policies.

In general, to address the damages posed by greenhouse gas emissions, economists recommend placing a price on those emissions, such as with a carbon tax or a cap-and-trade program. Many are skeptical of the need for additional policies, noting that once an emissions cap is in place, additional policies to expand renewable energy, for example, produce no new emissions reductions. (See a recent post by RFF University Fellow Rob Stavins of Harvard for more on this topic.) However, concerns about additional market failures, such as spillovers from innovation or the undervaluation of energy efficiency improvements, can justify additional interventions.

Together with colleagues Richard Newell of the Nicholas School at Duke University and Louis Preonas, of the University of California, Berkeley, in an RFF discussion paper, we examine the use of simultaneous policies to address these multiple market failures. We find that emissions pricing is still the single most cost-effective plan for meeting emissions reductions goals, and that carefully chosen coexisting policies can complement a pricing policy to help achieve additional outcomes. But, perhaps more important, we find that poorly chosen combinations of policies can vastly increase the cost of meeting emissions goals, relative to an emissions price alone.

This work builds on previous analysis by Richard Newell and me on different emissions reduction policies and how innovation and diffusion of renewable energy occurs in the US energy sector. We update this research and extend it by distinguishing between conventional renewable sources, such as wind and biomass energy production, and advanced technologies, such as solar, which have different costs and innovation potentials. We also consider the role of consumer behavior in energy demand, to assess the effects of undervaluation of energy efficiency. (Read more from our colleagues on this topic.)

We find that although carbon pricing is an effective policy mechanism, additional support for renewable energy innovation can improve cost-effectiveness by addressing the spillovers that occur from research and development (R&D) and learning-by-doing (LBD). With a calibrated model of the US electricity sector, we find that most of the benefits of technology policy are obtained by R&D support, whereas optimal deployment subsidies for LBD are quite low, particularly for conventional renewables. Even with learning spillovers, only modest deployment support is needed, in part because emissions pricing already makes renewables more attractive, in part because other cost-effective means of reducing emissions are available, and also because the costs of renewable capacity increase fairly steeply as generation expands.

Energy efficiency undervaluation is even more important to address, recognizing that energy demand is 10 times as large as renewable energy supply. Furthermore, correcting this market failure means one needs to rely less on renewable energy. Finally, our analysis shows that overly ambitious renewable portfolio standards, akin to those set in the European Union, can double the cost of meeting the emissions target, relative to using an emissions price alone, without any technology policy. There may be other reasons to want to support clean technology development more aggressively—such as to encourage adoption in countries with growing energy demand and less stringent carbon regulation. However, our analysis indicates some caution about relying excessively on subsidies to current deployment, as opposed to R&D, as a means of bringing down future abatement costs.